Dealing With ‘Transition Costs’

Closing the Michigan
Public School Employees’ Retirement System to new employees would prevent state
legislators from passing retirement system costs on to future taxpayers through
unfunded liabilities and questionable tinkering with abstract funding
assumptions. There are also ways a defined-contribution reform can minimize or
even eliminate the transition costs discussed above.

These dynamic approaches to transition costs appear
immediately below. Nevertheless, three observations should be made to put the
entire “transitions costs” argument into context, since “high transition cost”
is not as definitive an objection as it sounds.

First, using the flat (or relatively “frontloaded”)
level-dollar method for paying down unfunded liabilities is (at best) a
guideline of the Governmental Accounting Standards Board, not of the Michigan
Constitution.[*]
The Michigan Legislature is free to amortize its unfunded liabilities as it
sees fit, as long as it (or the various state employers) first makes sure to
prefinance retirement benefits — that is, to pay the normal cost.[†]

Indeed, GASB rules address how to account for financial
problems, not how to solve them. The rules are not meant to guide policy, nor
are they meant to allow governments to play games with payment schedules. In
fact, the board has emphasized that its rules should not be “about acceptable
public policy with regard to an employer’s contributions to a pension plan.”35

Thus, while GASB’s
methods of calculating an annual required contribution have been widely adopted
by state and local governments, and they will continue to be used in the
state’s financial reporting, there are no requirements that they guide funding
policy. Indeed, as discussed later, Michigan has frequently chosen to make
payments that diverge from them. This history makes the rigid insistence that
funding be driven by a different GASB accounting treatment for a closed pension
plan seem artificial. GASB’s rules for reporting financial activity should not
be a barrier to implementing a defined-contribution policy that would ensure
that retirement benefits for future members are affordable, predictable and
current.

Second, in an important sense, the phrase “transition
costs” is misleading when applied to the amortization payments on the unfunded
liability. If MPSERS pension system is closed, the frontloaded amortization
payments recommended under GASB guidelines in order to catch up on unfunded
pension liabilities do not represent increased total expenses, only increased
immediate cash outlays. The larger upfront deposits are similar to making early
payments on a mortgage. The payments do not change the underlying value of the
home (though it would lower the total cash payments on the mortgage).

Third, the “transition costs” objection to changing
MPSERS to a defined-contribution plan rests on the assumption that the normal
cost and the amortization payments on the unfunded liability provide a proper
accounting of the costs involved — an incorrect assumption that will be
analyzed later in this paper.

[†] The Michigan Constitution states, “Financial
benefits arising on account of service rendered in each fiscal year shall be
funded during that year and such funding shall not be used for financing
unfunded accrued liabilities.” “Michigan Constitution of 1963,” 1963),
http://goo.gl/eqXKV (accessed Jan. 23, 2012).